Loss underreporting and the auditing role of bank exams

Abstract

Using a unique set of banking data containing both originally reported and subsequently revised financial variables, we study the incidence of adverse revisions to accounting statements. As might be expected, our findings indicate banks are more likely to underreport financial losses when their financial performance is substandard. In addition, we provide evidence that supervisory exams have an important role in uncovering financial problems and ensuring bank accounting statements reflect them. Specifically, our estimations point to a significant auditing effect, through which exams can lead to a restatement of financial results to reflect a greater degree of financial difficulty than originally reported. Interestingly, this auditing role of exams is evident not only for institutions previously identified as supervisory concerns, but also at highly rated banks, where financial problems are only just emerging. Because a banking downturn would increase not only the number of problem institutions requiring additional supervisory attention, but also the incidence of loss underreporting at highly rated banks, our findings stress the value of efforts to maintain or bolster the supervisory system's capacity to expand exam activity quickly and substantially.

The Information Value of the Stress Test and Bank Opacity

“…We also add new evidence to the debate over bank opacity (Morgan 2002, Flannery et al 2004) and the related literature on the information value of government bank examinations (Berger, Davies, and Flannery 2000;Flannery and Houston 1999;Berger and Davies 1998;Gunther and Moore 2003).…”

How Do Joint Supervisors Examine Financial Institutions? The Case of State Banks

“…This literature has mostly evaluated the information contained in bank examinations (Flannery, 1983;Hirschhorn, 1987;Berger and Davies, 1998;Cole and Gunther, 1998;Hirtle and Lopez, 1999;Berger, Davies and Flannery, 2000;Allen, Jagtiani and Moser, 2001;DeYoung, Flannery, Lang and Sorescu, 2001) and, more recently, the impact of disclosing such information on supervisors' effectiveness (Feldman, Jagtiani and Schmidt, 2003) and the impact of exams on institutions (Gunther and Moore, 2003). I differ from these authors by analyzing how banks are examined as opposed to evaluating the effects of examinations or of the information obtained through them.…”

On the Market Discipline of Informationally-Opaque Firms: Evidence from Bank Borrowers in the Federal Funds Market

“…Karaoglu (2004) documents evidence that banks use the gains from loan transfers to influence both reported earnings and regulatory capital, even after controlling for other economic motivations. Gunther and Moore (2003) Financial Regulation made a proposal that the current risk-based capital framework be scrapped and replaced by tougher leverage requirements, part of which would be met through the frequent issue of subordinated debt by banks.…”